The Fair Price for Disruptive Companies
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Investors sometimes face serious doubts when trying to decide whether to invest in companies with strong disruptive potential. Many times these stocks trade at mind-blowing valuations, and it can be hard to evaluate if the stock price is fair or excessive. In certain cases it may be a good idea to simply forget about valuation ratios, earnings don't tell the complete story when betting on the future.
Think about Amazon (NASDAQ: AMZN), for example. The online retailer trades at a P/E ratio of nearly 170 times its earnings in the last twelve months. That's clearly above average and much more expensive than valuation ratios for other tech titans like Apple or Google. But earnings are sometimes just not comparable among different companies.
Amazon is launching new products and services at subsidized price in order to gain market share: the Kindle is aggressively priced for sales growth instead of profit margins contribution in the short term. Amazon wants to get a big piece of the tablet markets with Kindle, and profits will come in due time via eBooks and digital product sales. It's not about just one product, of course; Amazon sales many items at razor thin margins, or even at a loss, to continue gaining market share.
If we look at growth in sales and earnings over the last years, the numbers are quite explicit; Amazon managed to generate a 35% compounded annual growth rate in sales for the last five years, while operating income shows a 17.5% average increase in the same period. Amazon has been contracting margins on purpose to increase sales more rapidly, and that creates a dilemma for investors trying to decide a fair price to pay for Amazon.
In other cases, the difficulties don't simply reside in particularity of the company's financial figures. Some high growth companies are valued based on outstanding growth expectations, such as Mercado Libre (NASDAQ: MELI), for example. The eBay of Latin America is the undisputed e-commerce leader in the region, which obviously means extraordinary growth opportunities if Mercado Libre is able to sustain its leadership position in the long term.
The company is expanding even faster than Amazon, with sales increasing by more than 40% annually in the last five years, but Mercado Libre doesn't need to reduce margins in order to achieve those growth rates -- gross margins are above 75% and operating margins are north of 33%.
This is quite an exciting business, but it's also trading at a P/E ratio of more than 55 times earnings -- justifying those numbers via comparisons with “similar” companies or historical valuations is probably not the best idea. There are not many companies that can be considered similar to Mercado Libre, and the company is growing so fast that it’s not even comparable to itself a few years ago.
Other examples are even more complicated when it comes to determining a reasonable valuation. Companies like 3D Systems (NYSE: DDD) have true potential to disrupt many industries and our way of life. The Economist recently wrote about 3D printing in an article titled The Third Industrial Revolution, saying:
The old way of making things involved taking lots of parts and screwing or welding them together. Now a product can be designed on a computer and “printed” on a 3D printer, which creates a solid object by building up successive layers of material. The digital design can be tweaked with a few mouse clicks. The 3D printer can run unattended, and can make many things which are too complex for a traditional factory to handle. In time, these amazing machines may be able to make almost anything, anywhere—from your garage to an African village.
The applications of 3D printing are especially mind-boggling. Already, hearing aids and high-tech parts of military jets are being printed in customized shapes. The geography of supply chains will change. An engineer working in the middle of a desert who finds he lacks a certain tool no longer has to have it delivered from the nearest city. He can simply download the design and print it. The days when projects ground to a halt for want of a piece of kit, or when customers complained that they could no longer find spare parts for things they had bought, will one day seem quaint.
3D Systems stands to benefit strongly from the growth in 3D printers and related products, and sales expanded by a 63% in the last quarter; the company however has become profitable in 2009, so it doesn't have a big track record to show.
If things work out as expected for 3D Systems its current valuation of P/E 42 could seem like a ridiculous bargain for investors in a few years, but if it fails to live up to expectations, its lofty valuation ratio doesn't allow for much protection in a disappointing scenario.
Bottom Line: Forget About Valuations and Monitor Fundamentals
In some occasions there is simply no way of reaching a reasonable valuation estimate for certain high growth companies. Investors should probably accept that the current multiples are going to turn out cheap if the company does as well as expected, and there is no protection in terms of valuation in case things don't work out.
It's a bet on the future of an industry -- recent earnings don't add much information when making decisions on those kind of things. Instead of worrying too much about the right price for the stock, monitoring fundamental variables like competitive position and technological advancement can be a more fruitful effort.
When investing in disruptive high growth companies, the focus should be put on innovation and disruptive power, not on the company's valuation. Making decisions in this area is clearly more risky than in the world of value stocks with a proven track record and a more predictable future. The gains, of course, can be really fabulous if the investment works out successfully in the long term.
acardenal has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com and 3D Systems. Motley Fool newsletter services recommend 3D Systems, Amazon.com, and MercadoLibre. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.